Speculation is only a word covering the making of money out of the manipulation of prices, instead of supplying goods and services.

Henry Ford(1863-1947) American industrialist.

One hesitates to disagree with an icon of American business, but I write to correct Henry Ford’s misapprehension. Indeed, he is not alone. Consumers and legislators are fed up with the high price of gasoline today and are hunting for the guilty. The prime focus of attention is the speculator, whose murky world perhaps invites more fear and anger than just about any other in business. One blog (among many) raises the alarm that speculation is largely responsible for today’s high oil prices. As Kimberley Strassel wrote in last Saturday’s Wall Street Journal, Congress is in the process of cracking down on greedy speculators. What’s a business person to think?

Start with the understanding that the speculator takes a bet on the price of a commodity (oil, wheat, hog bellies, whatever) without ever really intending to take possession of the commodity. She (the speculator) isn’t interested in holding the bet for the long term. She just has a view about the fair value of the commodity and hopes to profit from that view. She’s an entrepreneur.

Speculators are important to the business person because they bring liquidity to the market. We don’t want less liquidity. To see the consequences of falling liquidity, see the subprime loan market and the repercussions on financial institutions, investors, and home owners. In addition, speculators make all kinds of insurance possible—they are the willing counterparties to a host of risks. Think of speculators as shock absorbers in the markets. To this point, some energy analysts at Lehman Brothers say that oil is as likely to rise to $200/barrel as to fall to $80/barrel. ((See “Oil Prices are Up and Politicians are Angry. Yawn.” In New York Times, May 11, 2008.)) That’s a lot of uncertainty. It is nice to have some players in the market willing to trade on that risk.

Writing in the New Yorker,James Surowiecki argues that speculation has little to do with the high price of oil—rather, producers and consumers of oil are fundamentally misreading the future. He quotes the oil pundit, Daniel Yergin, to the effect that there is a “shortage psychology” in the market. We should take mood swings very seriously. But to say that speculators are to blame for over-optimism or over-pessimism is to ignore the countervailing nature of markets: every speculative bet is offset by an equal and opposite bet. When the media say that the price of oil jumped today because of “frantic buying,” they are ignoring the fact that selling must have been equally frantic—down to the very last barrel traded that day.

Speculators are easy targets for an angry public. Speculation is often condemned as an immoral activity, like gambling, and often in contrast with investing, which seems to take the high ground. Yet the boundaries between speculation, gambling, and investing are fuzzy. In the best overview of this, Professor Reuven Brenner assessed the history of enmity toward speculators and concluded: “the role of futures markets in providing both insurance against fluctuating prices and liquidity for the participants in these markets has not been recognized by some vocal fraction of the population—just as the role of derivatives and many other financial innovations is not recognized today. Behind the apparent misunderstanding lurked suspicion, envy, and resistance to providing a channel for social mobility through which a new class of people were becoming rich.”

Henry Ford’s misapprehension is that speculation equates with market manipulation. That’s not right: speculation can be completely consistent with fair and competitive markets. We do care, however, to eliminate market manipulation. In Henry Ford’s heyday, before the era of market regulation, groups of individuals would band together to try to move stock prices up or down so as to harvest a profit from the rest of the investing public. (For more detail on this era, see the classic book, Reminiscences of a Stock Operator by Edwin Lefevre.) Today, it is quite difficult to manipulate a commodity market that is as vast and competitive as is the oil market. Markets that are easily manipulated send the wrong signals about resource allocation and the cost of capital to people in the real economy (such as producers and consumers of oil products.) Quash market manipulation, but let the speculators do their work.

Posted by Robert Bruner at 07/14/2008 10:28:10 PM